BY SHANE MOLIDOR ON FRIDAY, OCTOBER 18TH, 2019 5:18PM UTC
The role of a digital asset trading platform has advanced well beyond a forum to arrange trades between buyers and sellers.
This expanded role carries with it an evolving set of expectations from speculative traders and investors. It becomes imperative for them to understand the multi-faceted role of a trading platform, and different aspects of cooperation between digital asset projects, the platform, and supporting agencies referred to as Liquidity Specialists or Designated Market Makers.
My professional experience at some of the top digital asset institutions in North America and Asia (such as Gemini, BitMax.io, etc.) has allowed me to develop unique insight into the sometimes-controversial nexus between trading platforms and Liquidity Specialists. The content to follow seeks to explain the specific roles each institution plays in the fast-evolving digital asset ecosystem.
The Role of Trading Platforms & “Exchanges”
Trading platforms or “exchanges” serve as public utilities to facilitate interaction between buyers and sellers. Marketplace participants on a trading platform range from profit-motivated traders to utilitarian traders. The role of a trading platform in the digital asset ecosystem has evolved beyond that of a traditional market counterpart to encompass all aspects of “trade facilitation” including (1) an exchange, (2) clearing & settlement, and (3) depository operations. Accordingly, referring to platforms such as Binance, Coinbase, or BitMax.io as an “exchange” is a misnomer given that each operates as an all-in-one-platform: a “one-stop-destination” for trading, clearing, settlement, deposits, and withdrawals.
The increasing prevalence of “altcoins” has brought with it another role of a trading platform: an onramp for traders to access new assets. Accordingly, platforms compete with one another for “Primary Listing” given that quality projects tend to attract new customers to their respective platforms. Many platforms encourage listed projects to leverage the services of external agencies such as marketing firms and Liquidity Specialists to promote success following listing. In fact, BitMax.io requires all Primary Listing projects have a listing strategy that includes both marketing and liquidity support prior to and following listing on the platform. The BitMax.io team believes this holistic approach to listing is critical to fostering engaged project communities and efficient trading in the marketplace. A project’s willingness to reinvest in supporting those third-party agencies is one of many indicators used by the BitMax.io team to determine which projects to list on the platform.
This holistic approach to listing is not unique to the digital asset ecosystem — for example, private companies pursuing an initial public offering (“IPO”) leverage the services of financial institutions as “underwriters” to assist with marketing efforts, issuance, and active liquidity provision prior to and following listing on exchanges such as NYSE, Nasdaq, or BATS.
Despite a holistic approach to listing, an asset’s fundamental value (i.e., the ability of the asset or its associated blockchain network to provide utility) is the critical determinant of a project’s long-term success and price action following listing. Effective marketing can increase awareness of an asset’s utility, and strategic liquidity provision can promote trading efficiency, but the project itself is solely responsible for building value by achieving roadmap milestones, developing innovative technology, and growing the asset’s underlying network in support of its utility.
Some communities have become increasingly reliant on trading platforms to “list assets that pump” and often vilify platforms that list assets with poor price action following listing. While this is most certainly a symptom of the rampant “get rich quick” mentality that dominates many crypto investing communities, it is an outright misrepresentation of the role of a trading platform. As stated, digital asset trading platforms are, in essence, public utilities that facilitate trades among various participants. Trading platforms are not investment advisors and certainly do not provide guarantees on the future performance of each asset they list. While a platform does own the responsibility of performing due diligence and know-your-customer (“KYC”) on projects for quality listings, the price of each asset listed on the platform is ultimately dependent on the appetite of buyers and sellers to interact with one another (i.e., supply and demand) on the market place. The market forces of this supply and demand are driven by the fundamental value of the asset — of which the trading platform has no influence over!
The Role of Liquidity Specialists
Liquidity Specialists or Designated Market Makers are trading institutions contracted by projects to provide liquidity (bids and offers) following an asset’s listing on a platform. Some Specialists charge a recurring fee for their services and most trade with capital provided by the project itself (“Trading Capital”). Most Specialists are incentivized by a “performance fee” that stipulates compensation if the Specialist can effectively grow Trading Capital via a combination of Trading and Inventory Profit and Loss (“PnL”).
The goal of a Liquidity Specialist is to promote trading efficiency for an asset. This is facilitated via strategic liquidity provision, which in turn provides other market participants the opportunity to buy and sell with minimal market impact — effectively creating positive externalities in the marketplace. A related value proposition of a Liquidity Specialist is the facilitation of efficient price discovery as traders assess a newly listed asset’s fundamental value (i.e., the ability of the asset or its associated network to provide utility).
Because the goal of a Liquidity Specialist is to promote trading efficiency, the trading institutions will exclusively provide liquidity, rather than take liquidity. Accordingly, it is impossible for a Specialist to “pump” or “dump” the price of an asset because their trades do not and should not have market impact or “move the market” as would an aggressive order to take liquidity. Aside from this, buying or selling an asset with the intent to influence price (“pump” or “dump”) is widely regarded as a manipulative marketplace tactic; therefore, an institutional-grade Liquidity Specialist is unlikely to engage in such tactics.
Risks & Limitations Associated with Contracting Liquidity Specialists
Despite the critical role that the liquidity plays on the health of digital asset markets, contracting a Liquidity Specialist is neither a “silver bullet” nor a guaranteed catalyst for a project’s long-term success in token performance. There is a distinct set of risks associated with contracting a Liquidity Specialist. Most pressing is a drawdown in Trading Capital used by the Specialist to provide liquidity. This could occur for either of the below reasons or a combination of both:
1. If the Specialist is on the “losing end” of too many trades (i.e., selling low, and buying high), thus slowly depreciating the value of the Trading Capital. To further expand upon this, think of trading as a “zero-sum game” in which one side can only win at the expense of the other. In promoting marketplace efficiencies, the Specialist may purchase and sell an asset at inopportune prices, to the advantage of other profit-motivated traders — the “winners” in this case.
2. If a bearish sentiment causes significant selling pressure for an asset and erodes the willingness of traders to buy. If this occurs, the Specialist will be the only trader with an appetite to purchase the asset. If the large cumulative sell-side imbalance overwhelms and subsequently moves the market against the Specialist, their orders to buy will execute, and their newly established positions will result in an on-paper loss.
To mitigate the risks associated with Trading Deposit drawdown, projects provide Liquidity Specialists transparency on key metrics such as circulating supply, investor cost basis of tokens, and vesting schedules. It is extremely critical for Liquidity Specialists to have complete access to the accurate information around those metrics. Access to this information allows the Specialist to estimate the fair value of the asset and trade in an informed manner (i.e., avoid being on the overwhelmed by order flow imbalance) with proper estimates of various support and resistance levels in the pricing of an asset. Based on these estimates, the Specialist can provide liquidity aggressively or conservatively in relation to the asset’s price at any point in time.
A Project’s failure to disclose accurate information regarding circulating supply, investor cost basis of tokens, and vesting schedules can result in adverse information asymmetries wherein a Specialist may unknowingly trade at inopportune pricing levels to the advantage of other profit-motivated traders. In worst-case scenarios, cumulative sell-side order imbalance may overwhelm a Specialist repeatedly. This “toxic” order flow can deplete the Trading Capital significantly.
A further means to hedge the risks of Trading Capital drawdown is to incentivize Liquidity Specialists with performance fees to encourage preservation or growth of a Trading Deposit via potentially profitable trading (i.e., buying low, selling high) based on the market conditions and movement. This type of incentive structure may encourage a Specialist to trade conservatively with more discretion rather than providing robust and resilient liquidity at all times to promote trading efficiency.
In summary, the evolving role of digital asset trading platforms carries with it an expanded set of expectations from speculative traders and investors. Platforms can form synergistic relationships with external trading institutions such as Liquidity Specialists to support projects; however, the platforms are, by nature, price agnostic forums that arrange trades between buyers and sellers. While it is certainly true that projects with positive price action following listing (i.e., projects that “pump”) can be a powerful customer acquisition tool; a realistic perspective must be maintained on the influence that a trading platform or any Liquidity Specialist can have on an asset’s price insofar that neither is engaging in manipulative tactics.
The BitMax.io team will continue enhancing its due diligence and requirements for all future listings; however, there will undoubtedly be dissatisfied projects and speculators despite the robust nature of any platform’s listing process. As the Head of Business Development at BitMax.io, I will continue educating projects on the multi-faceted role of a trading platform and both the benefits and risks of cooperation with Liquidity Specialists. Most importantly, the BitMax.io team and I will maintain a steadfast commitment to our community to learn from past successes and missteps in order to continue growing the platform into a world-leading institution.
 Other types of Trading Institutions provide services to projects similar to Liquidity Specialists that employ both maker and taker execution strategies. A description of these types of institutions which I refer to as “Contracted Discretionary Traders” is outside the scope of this article.